Fiduciary duties - ESG and the risk of director negligence
Updated: Mar 16, 2022
This is article is a guest contribution by Fiona Donnelly, Director, Red Links Sustainability Consortium, and Kevin Bowers, Partner, bowers.law.
They explain how the need for directors to give appropriate consideration to environmental, social and governance (ESG) issues is not a matter of choice – it’s an integral part of being a board member.
The stewardship role and responsibilities of board members are built into the very structure of how companies are established. That is, board members take care of the assets on behalf of, and are accountable for their actions regarding a corporate vehicle to, the owners of that corporate – the shareholders. This responsibility to act in the best interests of another person or entity is a fiduciary duty.
Fiduciary duties and ESG
This means that, as part of their fiduciary duties, directors have a responsibility for material ESG issues – to ensure these risks are tracked, that opportunities are maximised and that value creation areas are optimised. Directors who fail to comprehensively and systematically consider ESG matters could well be deemed to be negligent in the performance of their fiduciary duties.
This may not be welcomed by ESG naysayers, who often see sustainability as a cost and a ‘nice to have’. But owners require, and increasingly stakeholders expect, organisations to look broadly and take a long-term and responsible perspective on the holistic sustainability of the enterprise. Financial success, whether in the short, medium or long term, is now only one measure that matters.
A surprising feature of the corporate world today is the widespread lack of awareness and understanding of the ESG risks and opportunities relevant to organisations like cybersecurity and existential megatrends such as climate change. The ferocity and frequency of extreme weather events is well documented and understood, but many companies have not undertaken an evaluation of the business-specific climate impacts of this trend and factored them into business decisions. It could be that board members of these companies could be found to be in breach of their fiduciary duties just in terms of this element of ESG alone.
Mind the fiduciary duties gap
Setting fiduciary duties aside, integrating ESG into business strategy is increasingly recognised as sound risk management and essential for the long-term success of businesses. There are more and more proof points that ESG does not come with a performance penalty – often it comes with multiple quantitative and qualitative upsides, including reputational gains, better staff retention and engagement, lower costs of capital and overhead savings. As noted in one recent BlackRock Investment Institute research analysis, ‘[sustainability] substitutions have little impact on the portfolio’s diversification or risk/return properties, strengthening our conviction that ESG integration is a “why not?” proposition’ (see ‘Online links’).
Board members are also individually and personally motivated to give ESG appropriate consideration, looking beyond fiduciary duties.
Executive compensation is increasingly under scrutiny. There is a growing trend to align executive pay to performance and long-term strategy in order to protect and create value. Including metrics relating to material ESG matters in executive pay decisions can help incentivise the achievement of sustainable business goals and show the conviction with which an enterprise is trying to achieve certain ESG outcomes. While this area is tricky when it comes to execution – issues include which ESG areas are relevant for a business and incentivise only the right strategic decisions, how to set and measure targets and over which timeframe – the principles can be straightforward. Businesses that properly integrate ESG will have material sustainability issues built into the core of the business, so structuring compensation in this way should not be a stretch.
With changes having been made to Hong Kong’s Companies Ordinance in 2014, company directors are being held to higher levels of personal accountability, responsibility and liability. The Hong Kong Companies Registry Guide on Directors’ Duties (see ‘Online links’) identifies the following broad principles (of which all Hong Kong directors should make it their business to be familiar):
to act in good faith for the benefit of the company as a whole
to use their powers for a proper purpose for the benefit of the members as a whole
not to delegate powers except with proper authorisation and retaining a duty to exercise independent judgement
to exercise care, skill and diligence
to avoid conflicts between personal interests and the interests of the company
not to enter into transactions in which directors have an interest except in compliance with the requirements of the law
not to gain advantage from their positions as directors
not to make unauthorised use of the company’s property or information
not to accept personal benefit from third parties conferred because of their positions as directors
to observe the company’s articles of association and resolutions, and
to keep proper books of account.
The fourth principle in this list is the most pertinent in terms of boards of directors devising and implementing ESG policies and procedures. The exercise of the directors’ care, skill and diligence is subject to both objective and subjective legal tests:
the objective test relates to the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and
the subjective test relates to the general knowledge, skill and experience that the individual director has.
The subjective element of this directors’ duty means that when directors are appointed to the board due to their special knowledge, skill or experience, they have a higher standard of care. Thus, when a company appoints a director to oversee its ESG policies and procedures, that person should be sufficiently qualified for the role and must then perform that function up to at least the standard of that individual’s qualifications. Essentially, the ESG director should have experience in ESG issues, so this function should not just be delegated to a random member of the board!
Furthermore, in a world where sustainability and ESG issues should be at the forefront of corporate decision-making, directors now have personal exposure if they allow their companies to operate without ESG policies and procedures, and without giving specific directors the role to oversee the ESG function.
ESG and crisis management
In extreme cases, if ESG matters go significantly awry, executives have been known to lose their positions. The pressure from shareholders among others led to the chief executive and two senior executives of Rio Tinto (see ‘Online links’) stepping down following the destruction of historically significant Juukan Gorge rock shelters and the way it managed its response. There was no way they could rebuild trust and confidence following their spectacular governance failure that saw this labyrinth of caves, which were thousands of years old, being irreparably damaged for the expansion of an iron ore mine. Even once those who have been held responsible have departed an entity, the new board then has to start the process of rebuilding reputation and trust in the brand and with the organisations’ various stakeholders, itself a lengthy, fragile and costly process.
The role of governance professionals
Governance professionals are clearly crucial to directors’ complying with their fiduciary duties. As a way to reflect on the appropriateness of board fiduciary behaviours towards ESG, governance professionals may want to reflect on the following questions.
Are directors appropriately familiar with ESG matters that are material to the business, particularly in terms of strategy, policy, issues and activities?
Is the board taking a forward-looking approach to ESG oversight, in particular by tracking emerging issues? Is the ESG risk/opportunity tracking appropriately holistic and based on an appropriate timeframe?
Are ESG matters delegated to appropriately knowledgeable individuals who are held to account?
When it comes to communicating and engaging with shareholders and broader stakeholders, are ESG matters shared to an appropriate level of detail?
SIDEBAR: An aside – fiduciary duty and investment managers
The UN Principles for Responsible Investment and UN Environment Programme Finance Initiative undertook a multi-stakeholder and multi-jurisdiction research, development and engagement exercise around fiduciary duties in the asset management industry. This entire project set out to end the ongoing debate on whether fiduciary duty is a legitimate barrier to the integration of ESG issues in investment practices and decision-making.
The first report – issued in 2014 – found that ‘failure to consider all long-term investment value drivers, including ESG issues, is a failure of fiduciary duty’. It was replaced by the second report, Fiduciary Duty in the 21st Century, issued in 2019. This asserts that the conceptual debate around whether ESG issues are a requirement of investor duties and obligations is now over, and the fiduciary duties of investors require them to incorporate ESG into investment analysis and decision-making processes.
More information is available at UNPRI
This article was first published in CSj, the monthly journal of The Hong Kong Institute of Chartered Secretaries, in June 2021.
External links are included for readers’ convenience. The inclusion of these sources is neither an endorsement of that provider nor intended to provide readers with any assurance as to the completeness or accuracy of the particular article linked. This content is for general information purposes only. It should not be used as a substitute for consultation with professional advisors.
ABOUT THE AUTHORS
Fiona leads the Red Links Sustainability Consortium which comprises some of the most experienced financially-minded, sustainability and business professionals in Hong Kong, with the goal of developing responsible business through strategy, engagement and sustainability services. Fiona is a renowned versatile operator with more than 25 years of experience in professional services in Hong Kong. She has been engaged in a wide variety of projects and long-term in-house advisory contracts with issuers, governments, academia and start-ups with a particular focus in sustainability, ESG and cleantech since 2007.
Kevin is a Partner at bowers.law. He is a dual-qualified lawyer in England & Wales and Hong Kong and has practiced as a commercial disputes lawyer and partner with three leading independent Hong Kong law firms over the last twenty years.
Kevin specialises in commercial, insurance and employment litigation and dispute resolution both in Hong Kong and internationally. He handles complex multi-jurisdictional commercial cases involving debt recovery, sale of goods, trade finance, media law, fraud, shareholder, joint venture, employment, property (including land rights disputes and building management / tenancy issues) and franchise disputes, contentious family/probate/trusts, asset tracing, injunction proceedings, jurisdictional challenges, public inquiries and judicial reviews.